Cover Story

Retirement: Why the Next Generation Needs a Plan

What's Happening to the Compensation Package?

by Elizabeth Kellar and Joshua Franzel

It’s the year 2043 and Cheryl, a 60-year-old public works employee with 30 years of service, has just reviewed her retirement savings with a financial adviser. She is surprised that she will need to work several more years to reach her retirement income goals. “My father retired from city government after 25 years and had a comfortable retirement,” she said ruefully. “What happened?”

To understand why Cheryl fell short of her retirement goals, it is instructive to look at the widespread changes that have been made to retirement plans in recent years.

To get pension funding on track, 45 states and countless local governments enacted major changes to their retirement plans from 2009 to 2012, according to the National Conference of State Legislatures. While the most common change was to increase employee and/or employer contributions, many governments made changes in the plan design, especially for new hires.

In a 2013 survey of International Public Management Association for Human Resources (IPMA-HR) members, the Center for State and Local Government Excellence (SLGE) found that 42 percent of local governments had made changes to their retirement benefits last year (see Figure 1) and 56 percent made changes to their health benefits.

The implications of these changes for a new employee are significant. Traditional defined-benefit pensions simply will not provide as much retirement income in the future as they did in the past. Saving for retirement will require more individual effort, although employers can make it easier for people to save.

Drivers of Change

For the past five years, most local governments have been scrambling to reduce costs. Since, for most local governments, labor is the largest cost center, there have been layoffs, hiring freezes, and changes to benefit packages. Much of the public focus has been on changes to retirement plans. There has been a robust debate about the relative merits of cash balance, defined contribution, defined benefit, and hybrid plans.

Most local governments have retained defined-benefit plans, adjusting them as needed to ensure their plans are well funded, covering both current and future obligations. One concern for city and county managers is how to address the management challenge of people working side by side with very different compensation packages.

Another concern is that new hires may not stay with the organization as long as desired in places where the years required to vest in a defined-benefit plan have increased from five to 10 years.

North Carolina State Treasurer Janet Cowell spoke about this dilemma at last year’s North Carolina City and County Management seminar: “The weakest aspect of our retirement benefit is for short-term employees. While they can get their own contribution back, they do not vest in the pension system and they lose the employer match. This is an area we need to improve.”

Significant Benefit Changes For New Workers

Overall, 82 percent of local government workers have access to a defined-benefit pension plan, according to the U.S. Bureau of Labor Statistics (BLS), and a little under a third of these workers have access to a defined-contribution plan.1 An analysis of BLS data also shows that state and local employer costs for defined-benefit plans increased from 5 percent of total employee compensation in 2004 to 8 percent in 2013.2

Local governments have made changes to their pension plans in recent years to make them more financially sustainable. Many of these changes impact those new to the workforce and early in their local government careers.

Among other changes, in 2012 and 2013, roughly one-fourth of local government human resource directors responding to SLGE’s annual workforce survey3 reported that their government had increased employee contributions for new hires over the past year. Somewhat fewer reported that their local government had increased the age and service requirements for normal retirement for new hires and/or decreased pension benefits for new hires over the past year.

These trends indicate that retirement benefits for newer workers are less generous than they have been for prior generations. Another factor that may affect retirement security is that newer workers are somewhat older than might be expected. As local governments began to modestly increase employment in 2012 and 2013,4 the average age of those who entered the workforce within the year prior to March 2012 was 43.5

Also, representing less than half of the local government workforce, as of March 2012, about 6 percent of the local government workforce was 24 years old or younger, 17 percent were between 25 and 34, and 23 percent were between 35 and 44 years of age.6

Secrets of Well-funded Plans

Well-funded pension plans share some common elements. In 2013, the Pension Funding Task Force, with representation from all of the major state and local government associations, made several recommendations. (See “Pension Funding: A Guide for Elected Officials” at http://icma.org/public_pension_funding.)

Kalamazoo, Michigan, is a good example of a fiscally distressed local government with a pension plan that remains more than 100 percent funded. How did they do it? For one thing, pension contributions have continued even when the plan reached full funding. That has allowed the city to weather investment losses by drawing on what is, in effect, a pension reserve.

Kalamazoo’s investment objective is to achieve a “real rate of return (nominal rate less inflation) of 5 percent over time. This objective has been achieved since 1982.” (See http://icma.org/kalamazoo_retirement_system.)

In addition to consistent funding of the ADC, governments need to ensure that their plan assets are managed professionally and that investment assumptions are realistic. Many governments have raised the full-retirement age and have eliminated the practice of “spiking” (e.g., including overtime, sick leave, or other extraordinary income in the pension formula). Sometimes local governments have had to press state governments to change laws so they can make adjustments to maintain a properly funded pension plan.

Pension liabilities have been cited as a factor in some prominent municipal bankruptcies this year: Detroit, Michigan, and, in California, San Bernardino and Stockton. Although pension and compensation costs have added to their fiscal problems, in fact these governments had long been on a credit-watch list for a variety of reasons, including a shrinking revenue base, high legal costs, corrupt or inept leadership, and/or bad investments.

Good management is even more important to a local government that is experiencing fiscal stress, whether addressing needed pension reforms or using technology strategically. Are pension problems likely to prompt a rash of bankruptcies? That is unlikely, especially since only 12 states allow Chapter 9 filings. Fourteen localities, less than 1 percent of those eligible, have sought bankruptcy protection in the past five years.

Learning from Reforms

Before local government leaders tackle pension reform needs, they need good information. Annual briefings from pension plan sponsors are essential and long-term financial modeling should be used to evaluate plan benefits. Some governments hire their own actuary to get an independent analysis of their pension plan.

Most pension plans have manageable funding problems that can be addressed by increasing contributions from employers and employees and making changes in plan benefits for new hires. More dramatic changes, however, will be required in some places. The funded status of 22 percent of the 126 plans in the public plans database (PPD) slipped below 60 percent in 2012, according to a June 2013 study published by SLGE and the Center for Retirement Research at Boston College, “The Funding of State and Local Pensions: 2012–2016.”7

Atlanta, Georgia, has faced serious funding challenges. In 2010, its pension plan was just 51 percent funded and the city was spending 20 percent of its budget on pensions. To deal with these issues, Atlanta established a hybrid plan with a mandatory defined-contribution component for new hires, which also is an option for current employees.

Current employees were given the option of contributing an additional 5 percent of their salary to remain in the defined-benefit plan, and the cost-of-living increase was capped at 1 percent. Employees hired after September 1, 2011, at grade 19 or above no longer have a defined-benefit component to their pension; they participate in the defined-contribution plan only. Beginning in FY 2012, the city also established a ceiling of 35 percent of payroll for its contribution to the three defined-benefit plans.

Sometimes pension plans are restructured to gain more control over pension assets and to meet specific human resources goals. When Gwinnett County, Georgia, took over management of its pension fund in 2007, it closed its defined-benefit plan to new employees and offered them a defined-contribution plan instead.

The county made this change to attract younger professionals and to control pension cost increases. The closed defined-benefit plan has been more costly to fund than the county expected because of the 2008 economic downturn and stalled growth in county revenues. At the same time, Gwinnett County has achieved its goals of improved recruiting and controlling costs in the long run.

Factoring in Retiree Health Costs

Health benefits, including retiree health benefits, have experienced some of the most significant changes. For newer workers, the changes can be dramatic.

As of 2012, 86 percent of local government employees had access to health care,8 with 66 percent of those under 65 having access to retiree health care and 59 percent of those 65 or older having access.9 From an employer cost perspective, employee health care has increased from 10 percent of employee compensation in 2004 to 12 percent in 2013.10

The cost issues have been significant for employees as well. Analyzing recent BLS data, wage and salary earners of all sectors have seen their health care costs increase by 45 percent from 2004 to 2012 and retirees by 30 percent during this same time period.11

Against this backdrop, local governments have made many changes to the health care benefits they provide to retirees. Adjusting retiree health benefits is often easier than making changes to pensions. It is common, for example, for governments to alter copayments, premiums, and deductibles.

Among other changes, SLGE, IPMA-HR, and National Association of State Personnel Executives workforce surveys show that in 2012 and 2013, about 10 percent of local governments shifted more costs to retirees in the form of higher premiums, copayments, and deductibles; less than 4 percent eliminated retiree health care programs; and about 3 percent shifted new employees from traditional retiree health care plans to defined-contribution plans. An example is retirement health savings plans.12

Given these changes, it is not surprising that, in 2012, 30 percent of state and local workers under the age of 45 were “not too” or “not at all” confident that they will be able to pay for medical expenses in retirement; 22 percent were very confident.13

Steps to Take Now

What can hiring managers do to attract and retain the people they need to fill challenging positions? They can start with a clear-headed assessment of the work that needs to be done and the skills that will be required in the future.

High-achieving employees want to work in a place where they can learn and grow and they want flexibility. Local governments can provide training to meet their needs and also can partner with academic institutions to do so.

Staying competitive will not be easy in an era when benefits have been trimmed. If local government retirement benefits start to look more like private sector benefits, salaries for some positions may need to increase to attract and retain qualified candidates.

Some retirement plan structures also pose such challenges as attracting mid-career candidates who may balk at a long vesting period for retirement benefits. Having flexibility to deal with such hires will be important.

Equally important, individual employees may need to take more responsibility for their own retirement savings. Employers can help by offering automatic enrollment in defined contribution plans and providing incentives to save.

Most local governments have been models of fiscal responsibility, especially when it comes to funding their retirement plans on a consistent basis. They understand that employees, employers, and taxpayers have a shared interest in coming up with fiscally responsible solutions that provide retirement security for public workers.

And if that happens, employees like Cheryl who are hired in 2014 will be able to reach their retirement goals in 30 years.

Authors' Note: Information about Atlanta, Georgia, was found at the pension website http://www.atlantaga.gov/index.aspx?page=214 and by a conversation with Louis Amis, department of human resources, city of Atlanta, on September 27, 2013.